Lending vs Liquidity

There are three fundamental building blocks in DeFi:

  • Liquidity (Automated Market Makers such as Uniswap, Curve Finance or Balancer)

  • Lending (Lending Protocol such as AAVE, Compound or Liquity)

  • Stablecoins (Non-Custodial stablecoins such as FRAX or USDFI)

Although liquidity, lending and stablecoins are all crucial to the growth of DeFi, they differ in their ability to promote inclusivity within the ecosystem. While we delve into the technicalities of how swaps are executed in another chapter, we shall explore some key distinctions between these two mechanisms.

Persmissioned and Permissionless

Advanced AMMs such as Uniswap provide a feature called permissionless listing, allowing anyone to create a pair or pool of tokens and have it displayed on the Uniswap interface. This means that any token project can obtain on-chain liquidity for swaps from the beginning without the need for approval or listing fees. In contrast, leading lending networks such as Compound and Aave require a governance decision to add a new Money Market, a process that is challenging to pass. As a result, only a limited number of privileged tokens have access to lending and borrowing services.

The challenges of listing a new token on a Money Market

Let us delve into the distinct risk management approaches of Money Markets and AMMs by examining Compound and Uniswap as examples. Uniswap consists of numerous isolated pools that operate independently of one another. Each pool imposes its own risks on users, meaning that individuals who do not interact with a particular pool are not subject to its risks. Uniswap's security strategy relies on this isolation principle, allowing anyone to create any pool they wish, and providing users with the freedom to interact with the pools they deem safe or trustworthy.

However, this method is not feasible for Compound. If a single Money Market in Compound turns out to be problematic, all users, including those who have not interacted with it, will be exposed to risk. This is because borrowers in the risky market can obtain funds from any other market, and any market could suffer losses if the borrowers fail to repay their debts. Thus, Compound's risk management differs greatly from Uniswap's, as it assumes responsibility for the safety of its users and follows a gated approach. Compound's users must trust its governance processes to make prudent decisions that mitigate risk and safeguard their collateral.

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